Chapter 6.1

A bitcoin exchange is a digital marketplace where traders can buy and sell bitcoins. In the early days of bitcoin, when bitcoin was the only cryptocurrency, exchanges were dedicated entirely to buying and selling bitcoin.

Today, most exchanges do not specialize exclusively in bitcoin. Today, most exchanges are cryptocurrency exchanges that offer a diverse range of trading pairs. You can find bitcoin, Ethereum, Bitcoin Cash, Litecoin, and dozens of other popular cryptocurrencies all listed on today’s major cryptocurrency exchanges.

Why Do We Need Bitcoin Exchanges?

Bitcoin is a decentralized cryptocurrency built using peer-to-peer transfer technology. Why do we need bitcoin exchanges? Isn’t the point of bitcoin to transfer money without the need for a centralized authority?

This is all true! Today, bitcoin continues to be easy to transfer from person to person (P2P). However, P2P transfers aren’t ideal for most trading activities.

With P2P transfers, there are certain drawbacks. If you want to buy 10 BTC from the market immediately, then you need to find a seller willing to sell you 10 BTC. This can be a time-consuming and expensive process. A bitcoin exchange organizes trades. It matches buyers with sellers over a trading engine. Buyers can purchase bitcoin simultaneously from a multitude of different sellers.

Bitcoin exchanges are also useful because they facilitate cross-chain transfers. Completing a P2P transfer between bitcoin and Litecoin is impossible. Sure, you can send bitcoin to someone’s bitcoin address and they can send Litecoin to your Litecoin address in return. However, this exchange doesn’t take place simultaneously. A bitcoin exchange facilitates cross-coin and cross-chain transfers, allowing you to trade bitcoin for altcoins and vice versa.

How Do Bitcoin Exchanges Work?

Bitcoin exchanges or cryptocurrency exchanges all work in a similar way. They function like a stock exchange by matching buyers with sellers.

The main purpose of an exchange is to match buy orders with sell orders. Buyers are trying to buy bitcoins while sellers are trying to sell bitcoins. A cryptocurrency exchange matches these two parties together to facilitate a trade.

Types of Cryptocurrency Exchanges

There are multiple types of cryptocurrency exchanges. In the early days of bitcoin and crypto, most exchanges were centralized custodial exchanges. Today, we’re seeing an increased number of non-custodial exchanges and decentralized exchanges. However, 99% of bitcoin trading activity continues to take place over centralized exchanges, with most centralized exchanges being custodial exchanges.

Confused? Here are the three main types of cryptocurrency exchanges, including custodial centralized exchanges, non-custodial centralized exchanges, and decentralized exchanges.

Custodial Centralized Exchanges

In a custodial bitcoin exchange, the exchange holds your cryptocurrencies within its own wallets. You don’t have full control over your cryptocurrency funds. They’re held in the wallet of the exchange. Today, approximately 75% of cryptocurrency exchanges are custodial exchanges: they hold the funds of users in wallets on-site. If a user wants to withdraw funds, he or she needs to submit a withdrawal request, at which point the coins will be removed from the exchange’s wallet and sent to the user’s wallet.

The vast majority of popular bitcoin exchanges – like Bittrex, Bitfinex, and Gemini – are custodial exchanges. You’re expected to deposit funds into the exchange and trust the exchange to keep your funds secure.

Custodial exchanges have pros and cons. The biggest concern is that you need to trust the exchange to manage your funds. Major cryptocurrency exchanges are constantly bombarded by hacking attacks. Periodically, a hacker breaks past the defenses and steals cryptocurrency. We saw this with the Mt. Gox hack in 2014: Mt. Gox once handled 75% of bitcoin exchange traffic before it got hacked. Then, it lost hundreds of millions of dollars’ worth of bitcoin overnight, leading to catastrophic consequences.

Custodial exchanges are considered to be “centralized” exchanges because your money is stored in a centralized wallet. Your orders are matched by a centralized matching engine. There’s a private, closed platform that acts as the middleman between the buyer and the seller. You pay a fee to this centralized authority and trust that they’ll complete trades fairly.

Non-Custodial Centralized Exchanges

Non-custodial exchanges are another type of centralized exchange. With a non-custodial exchange, you can interact with buyers and sellers over a centralized matching engine. Your funds, however, remain in your control during the trading process. You don’t need to relinquish custody of your funds. It’s a non-custodial trading platform.

In other words, a custodial exchange holds your money while a non-custodial exchange does not hold your money.

In a non-custodial exchange, your money is never held by the exchange. Instead, all trades are made instantly between buyers and sellers. The buyer receives your coins the same instant you receive the seller’s funds. You don’t need to deposit funds into a centralized account or wallet for trading.

The best-known non-custodial exchanges available today include Shapeshift, Changelly, and Evercoin. All of these exchanges allow you to swap tokens instantly – in exchange for a fee – without actually depositing your coins into a centralized platform.

Decentralized Exchanges

Decentralized exchanges, or DEXs, currently account for about 1% of cryptocurrency market trading activity. Some believe that DEXs are the way of the future, while others believe they’re too impractical to ever take off.

In any case, decentralized exchanges work much differently than the two centralized exchange types mentioned above. A decentralized exchange uses an open-source, permissionless, on-chain platform where trades can take place. That means there’s no need to trust a third party with your private keys. You don’t need to match with a buyer or seller across a centralized matching engine.

How can trades take place if there’s no centralized matching engine? Decentralized exchanges use smart contracts on the Ethereum network (or other blockchain networks) to facilitate trades between buyers and sellers. The biggest decentralized exchanges available today typically specialize in ERC20 token trading.

Instead of trusting a centralized third party, decentralized exchanges allow you to trust smart contracts on the Ethereum network. You need to put a lot of faith in the smart contract itself. However, you’re free to check this open-source smart contract at any time to verify everything is correct.

Today, decentralized exchanges are not a legitimate threat to the future of cryptocurrency exchanges. However, things could easily change within 2 to 5 years.

One thing that could make decentralized exchanges more prominent is cross-chain atomic swapping. This technology allows cryptocurrencies on different blockchains to be traded for one another instantly. Up above, we mentioned that buyers and sellers exchange coins instantly, with no lag or need to transfer coins between a centralized party. Cross-chain atomic swapping could allow that for more than just ERC20 tokens: it could allow it for all blockchain-based cryptocurrencies.

There’s one big problem with decentralized exchanges today: they account for just 1% of trading activity on the market. This means liquidity is an issue on many decentralized exchanges. It can be difficult to match buyers and sellers outside of the top cryptocurrencies.

The most popular decentralized exchanges available today include IDEX, Waves DEX, OpenLedger DEX (run by Bitshares), CryptoBridge DEX, and Bisq (run by BitSquare).

Types of Bitcoin Exchange Orders

Generally speaking, there are two types of orders on a bitcoin exchange, including market orders and limit orders.

Market Orders: With market orders, a trader can buy or sell bitcoins immediately based on the best currently available price. If you want to buy or sell crypto at the last price at which it was bought or sold, then a market order is what you want to do.

Limit Orders: A limit order allows you to set a specific limit at which you’ll buy or sell a particular asset. You might not feel comfortable buying bitcoin at $10,000, for example, so you set a limit order to buy 0.5 BTC at $7,000. If the price of bitcoin falls to $7,000, your order will be processed and you’ll purchase bitcoin from the market at $7,000 per BTC.

Makers and Takers

There are two participants on bitcoin exchanges, including makers and takers. When looking at a bitcoin exchange’s fee structure, you’ll typically see a maker fee and a taker fee.

Makers: A maker is someone who “makes” an order on a bitcoin exchange. You might “make” an order when you offer to pay $7,000 per BTC. You’ve now made an order and that order will set on the order book until someone “takes” it.

Takers: A taker is someone who “takes” an order from a bitcoin exchange. You might visit an exchange and see an offer from a buyer willing to pay $7,000 per BTC. You accept that offer and “take” the order.

Generally speaking, cryptocurrency exchanges want lots of orders posted on their exchange for maximum liquidity and the lowest possible spread. That’s why takers typically pay lower fees than makers. An exchange might set a maker fee of 0.1% and a taker fee of 0.2%.

How Do Bitcoin Exchanges Make Money?

Transaction Fees

Bitcoin exchanges make money by charging a transaction fee. The vast majority of exchanges charge a transaction fee. Unless an exchange is in a brief promotional period, you’re unlikely to find an exchange charging 0% transaction fees.

Exchanges generally offer volume-based discounts for higher-volume traders. If you trade, say, more than 50 BTC per month, then you might pay fees of just 0.01% on some exchanges, for example.

Additional Fees

Transaction fees are one of several was bitcoin exchanges make money. Bitcoin exchanges also make money through:

Deposit Fees: Some exchanges charge a fee to deposit money into the platform. Other exchanges charge no deposit fees whatsoever but charge higher fees upon withdrawal.

Withdrawal Fees: Virtually all exchanges charge withdrawal fees. Some exchanges have a certain minimum amount required before you can withdraw. You might pay 0.0001 BTC to withdraw your bitcoin from the exchange, for example. This fee can cover the exchange’s own transaction costs, including the fee paid to use the bitcoin network.

Currency Conversion Fees: Certain local exchanges will charge currency conversion fees. The exchange might offer to transfer your Canadian Dollars or Australian Dollars into bitcoin, for example. There are few exchanges that offer CAD/BTC or AUD/BTC pairs, so these exchanges are charging an exchange rate fee for the convenience.

Cryptocurrency exchanges are extremely profitable. In March 2018, Bloomberg analyzed the activity of the top 10 cryptocurrency exchanges in the industry. They calculated that the highest-volume exchanges – like Binance, Upbit, Huobi, and Bittrex – were generating $2 to $3 million per day in trading revenue. The majority of this revenue comes through trading fees, including maker and taker fees as mentioned above.

Conclusion

Ultimately, the world of bitcoin exchanges used to be the Wild West. There were no regulations, limited security measures, and varying fee structures. Today, the world of bitcoin exchanges is a highly competitive environment filled with major players and high-volume exchanges that offer competitive fee structures and enterprise-grade security while processing millions of dollars in transactions per day.

In the next chapter, we’ll list the most popular exchanges available today, including which cryptocurrency exchange or bitcoin exchange might be the right choice for you.